Notes From Underground: Yield Curves Are Needles and Pins

I saw her today, I saw her faceIt was the face I loved, and I knewI had to run awayAnd get down on my knees and pray,that they go awayStill it beginsNeedles and pins

These lyrics seem to describe the market’s relationship with Janet Yellen and her FOMC board. When I blog about yield curves it seems to elicit the greatest response as traders are trying to position themselves in a low-risk, high-reward trade. There was a question on last night’s POST from RLD concerning the 2/10 curve and the possibility of buying bank stocks, if my thesis about a steepening curve reaction to QT is correct. This is an interesting query and reflects on the intelligence of the readers of NOTES. The mainstream media reports on the relationship of yield curves and bank stocks in a regular fashion and theorizes that the correlation is high: Steeper curves beget higher bank revenues resulting in higher bank stocks.T he correlation is far from consistent as bank stocks were making highs in 2007 even as the curve dramatically flattened.

A similar pattern also played out in early 2000 as the dotcom bubble was imploding. In April 2000 the 2/10 yield curve inverted to -56 basis points while shares of JPMORGAN was making the all-time highs. I AM WARNING THAT WHILE THE FINANCIAL MEDIA TOUTS THIS CORRELATION THERE IS AN IMPERFECT TIMING TOOL TO MAKE THE TRADE. Historically, the 2/10 moving average over the last 20 years is 109.70, so today’s close of 89.9 basis points is not flat by a broader time horizon.

Also, because of RLD‘s question I looked at this relationship in Japan, which has been pegged at the zero bound for many years. I have included a Bloomberg chart of an overlay of the Japanese 2/10 curve versus the Topix Banks Index over the last 20 years. Notice the extreme divergence of the yield curve to bank equity prices for several years and this was as the CURVE STEEPENED. Now the U.S. banks are far more secure than Japanese banks were and should see increased valuations should loan activity pick-up.

On his Epsilon blog, Ben Hunt has conjectured that the beginning of the FED‘s balance sheet shrinkage will result in increased monetary velocity. If Ben Hunt is correct then the FED‘s QT ought to result in the combination of a steeper curve and increased bank profits. But with all things, timing will be KEY. Yesterday, I noted the 20 basis-point range the 2/10 curve has been sitting so I urged patience. The 200-day m.a. is 109.70 basis points, solidifying the important of this range top. My warning is that these historical relationships have been debased by the actions of the world’s central banks so even the best of the global macro traders have been led down false paths.

The bottom line is the Fed, BOJ, BOE and ECB have created what Colin Powell would refer to as a POTTERY BARN GLOBAL BOND MARKET. They broke the market therefore they own it. For now! But as I have warned, HELL HATH NO FURY LIKE A MARKET SCORNED. I am down on my knees and pray they go away … needles and pins.

***Today the IMF released the data on the Swiss National Bank foreign currency reserves, which reached a record high on weaker franc. In July as the Euro/Swiss cross was making 30-month highs, the SNB was busy adding 20 billion in foreign exchange reserves. The printing presses were busy as the SNB was creating francs and selling them for euros, dollars and other foreign currencies, and investing the proceeds in a basket of foreign bonds and the stocks of more than 3,000 global corporations. The Swiss show that there is no end to the quantitative easing entered into by the central banks because the EURO/CHF cross has rallied to the highest levels since the January 2015 removal of the 1.20 PEG. What exactly is the SNB trying to accomplish beyond the greatest feat of alchemy in world financial history? Now I will listen to Jackie DeShannon’s 1959 hit.

Toni Fisher on the original ’59 version was tops. Will the expected QT bring about “the Big Hurt”? One way to steepen the curve might be to dump bonds in large tranches into the market, dropping prices and raising rates. That is, if there is appetite for bonds. Once the market sees them coming will they want to bid them up or just hold back? Market psychology (psychopathy?), isn’t as predictable as we would like it to be, so I’m not betting.

Wouldn’t commodity & price inflation do more to steepen the curve than CB tinkering? In a future that may well be characterized with currency wars (the SNB is already in full battle mode), does anyone really expect CB “tightening” to be more than a temporary blip?

Yra,
Very nice analysis, and excellent choice of tunes!
Like many, I’m very skeptical of the “buy banks… the curve is steepening” trade. IMHO, bank earnings are either near, or have peaked for this cycle. What no one wants to discuss is the fact that their COST of funds has not yet risen, as financial repression continues. IF the curve steepens, the further assumption is that ONLY the long end rises, AND that deposit rates stay at zero.
I’ve never had any good luck betting on compound probability odds, saying nothing about rising delinquencies of outstanding loans. 18 months ago was the time to be buying bank stocks, not for the coming 18 though. Just a thought….

Have a friend a F&I guy at a Nissan dealership he tells me excess and he says excess inventory on car lots and foot traffic way way down. Every new car or late model car you see on the street 60% of them are upside down on cars owned…. average monthly car payment is between $550 and $625.

Chicken—in January I noted that the Peso was the cheapest asset class in the world –if the Mexican peso would break down I would be interested but I think the Peso has become more balanced at recent prices ,But ilike your thinking very much

Yra
If Ben Hunt is right that QT will lead to higher monetary velocity which lifts inflation and steepens the yield curve, doesn’t that framework begin to explain, perhaps, the “unusual” sell off in USD in the face of higher, not lower, short term rates.

Perhaps Ben Hunt’s framework is the proper lens to evaluate the world of CB unwinding which will dominate the markets in the coming years.

As for further pressure on USD, President Trump is a negative as foreign capital cannot be too bullish on Brand USA these days. Sometimes, politics really do matter.

As for CHF, perhaps the SNB should be careful what it wishes for. If we see a big equity sell off in coming year(s), that SNB equity hedge fund will be a disaster